Macroeconomic and financial market commentary

Fed up with fake markets (but still in the money ytd).

“According to Hoisington, debt in the U.S., that has jumped from 200% in 1987 to about 370% now. In the euro zone, it has gone from about 300% of GDP in 1999 to more than 460%. Japan’s debt stands at a monstrous 650% of GDP, while China’s total debt has quadrupled since 2008, to 300% of GDP.”

Barrons, 20th of february 2016

Using various statistics, Paul Singer recently summarized the total nominal value of global debt at 161 trillion, while global market cap., as defined by the World Federation of Exchanges, comparatively floats just above the 64 trillion mark. Sobering numbers. It pays to refocus every now and then, on what really matters. Like debt.In fact, I think it is an indispensable obligation. The stream of social, economic and market events of late flows faster and faster yet -in a seemingly unstoppable acceleration. QEs, LTROs, ZIRPs, NIRPs, CoCos, and a large list of acronyms, speak for the financial revolution taking place worldwide. It is easy to get lost in the media narrative, if not in the details. The devil lives there, and if you lose sight of the big picture you are lost (regardless of translation or not). Now is not the time for bottom-up approaches. The big picture is overwhelming.

Ubiquitous debt is the name of the disease, and most of the pathology in actual global economic performance is caused, directly or remotely, by the debt overhang. Too simple? I am cognizant of the limits to simplification. Einstein constantly mentioned that processes and realities ought to be outlined as simply as possible, but no more. The debt overhang is, of course, not a simple stand-alone concept (nothing in economics is), and is deeply rooted in the easy money policies of the last 25 years, regardless of Keynesian denial.

In truth, it is fair to say that easy money in itself can not affect the real economy negatively (or positively), if it has not morphed into asset bubbles, malinvestments, or altered inflation levels. Krugman has been fast to vindicate his success, regardless of belatedly allowing for a questionable efficiency of the monetary policy he endorsed over the last couple of years, those policies did no harm -conveniently forgetting the second round effects of those policies. Ain’t he smart! Somehow, miraculously, Keynesian priests never seem to be at fault.

Excess money is then, apparently, only a benign malfunction of the system. Hence, at the end of the day, it has to be something else (and not the Princeton doctrine) that spoils the party.

Like debt accumulation or inflation. Up to know, the former has indeed played the primary role as a GDP growth buster, but the role of inflation might be upgraded if easy money persists -and relentless printing to support the “statu-quo” ensues. At some point (not linear and thus impossible to predict accurately) it will alter the equilibriums in the economic system. Not likely in the short term, but not to be discarded lightly for the longer run. Stanley Fisher keeps on mentioning the issue, and I think he is one of the few central bankers to deserve our respect.

Or like asset bubbles or malinvestments. They are, of course, the sole cause of the problem. Helicopters, printing presses, and their respective pilots and maintenance engineers are not to be blamed for that. After all, according to Ben, literally, Monetary Policy is too blunt a tool to prevent them. Even if it is now crystal clear that monetary recipes did not work as expected (something we have for years been arrogantly stating was sure to happen), Keynesian priests are not to be blamed: all their zirping, printing and, late nirping, did no direct harm to the real economy. Have Keynesian priests never read Frederic Bastiat?

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.”

Debt matters and monetary policy has notorious side effects.“Malheureusement“,for as long as we keep the debt overhang growing, the only way to stabilize the system is pervasive monetary debasement. Options for that questionable end are: printing in the reserve currency (the most effective stabilizer), printing in other currencies (inconveniently it generates USD strength), or nirping away the value of the currency kept as long term savings. Not to mention the permanent and constant redistribution of income from savers to debtors, and all the economic inconvenient it generates (moral issues aside). It is for that main reason (and some others) that I am totally confident that reigniting growth is incompatible with the maintenance of the debt overhang. Japan showed us the way. At best, we will muddle through, with low growth and deteriorating debt ratios, and increasingly unfunded entitlement contingencies.

On a different note, markets just moved up dramatically, and I have been adamant about the continuation of the downward moves in equities and credit spreads (particularly in the low to below investment-grade universe of debt securities). The market has proved me wrong.“Mea culpa”.Maybe I should refrain from further Keynesian bashing while my reputation is at stake. I ought to Forget Paul and Ben, and try to make money -and help my readers make money. What about equity prices? What’s going on?

Anybody heard of the acronym “PKO”? It is normally used as the short name for “Peacekeeping Operations”. But I think “price- keeping operations” is a better fit -as an underlying concept. It was naive to think that the G20 would do nothing to abort the downward spiral in financial markets. The very next Monday they were at it again, and the results were perfectly coincident with what happened after the October 2014 “Bullard” low, or, more recently, what happened after 2015’s August low. History not only rhymes, but it frequently repeats as well.

“There are a variety of [price-keeping] techniques. Basically, the government spends a huge amount of public funds to shore up share prices directly. … [Or] instead of using cash on hand, it can employ a subtle method called ‘questioning’ to intervene in the market. Bureaucrats never come off as forceful in their speech but simply ask questions: ‘Why are you selling?’ or ‘Prices are down considerably, aren’t they?’ Officials at financial institutions read between the lines and act accordingly. It is a world of tacit understanding.”

Nikkei front-page story headlined “Bureaucrats” on Dec. 11, 1993

We “homo not so sapiens” never learn from our previous mistakes. We are following the Japanese path step by step. And we know where that took them. After the Nikkei price collapsed below the 20.000 level, the establishment engineered a long-lasting rebound to 22660 -only to see prices end up plunging to below the 8000 level years later. I traded the Nikkei back then. I am old enough to be trading at such a distant past, but not old enough to forget. I remember the pricing inconsistencies, the absurd last hour rallies … It was difficult to understand back then. We only learned about it years later. Trading a rigged Nikkei will make certain that you spend not few sleepless nights, for a sure loss as a result. Particularly if you are a European resident. I remember them vividly. And in the end …well, in the end, the Nikkei ended below the 10.000 mark! CB’s never change the tide for keeps (the tide is a moving element anyway). You just have to wait patiently -and take the necessary precautions to ensure you remain solvent in the meantime.

This global equity bounce is thus “dèjá vu”. We do not know how long it’s going to last, or how far it is going to take us. But we do know that, unless some heavy printing backs it up, it will not succeed. Printing can crush all shorts big time, but nothing short of that will push the market upwards on a continuous sustainable path. Having said that, the daunting scenario for shorts is some serious PKO induced mark to market book loses, and significant printing following suit -without allowing those trades to come out in the black in the process.

Printing can make your short position’s book loses permanent -and you never know when or if it is going to take place before you make money on that trade. You can’t really bet the ranch to see the FED’s bluff, if only because you do not know if and when they will print some more to support their PKO. There is always an amount of printing that will produce Argentinian or Bolivarian bull markets for equity. Yes, even for the US. Let’s hope they don’t give it a try. Printing is a prudent bear’s nightmare -however right he might have been in his valuation or flow of funds analysis. Printing changes everything!

By the way, the fact that this oversold global equity market has seen a bounce, conveniently increased by a short squeeze induced by a PKO scheme, is not a disclaimer. The same as everybody else, I get it wrong every now and then. Mea Culpa (play it again Sam!). I should have factored that into the equation because it is hardly the first time they are at it. But it is relevant as a concept. CB’s are working the markets psyche in true Goebbels style, using price movements to induce in market players the idea that the bounce proves that everything will be OK, and there was no reason for the previous market rout. Hey, for what it’s worth, please consider the fact that some people still believe in Fama’s Efficient Market Hypothesis (I’d rather believe in Superman and his superpowers). That is the reason for not intervening in the open. They want you to think it is the market that generates the sharp bounces. You play by their rules long enough, and it becomes your game. Most commonly, you even fail to notice.

If we try to fade the actual PKO success and think about where we go from here, we have to go back to the market drivers. Liquidity is the most relevant driver after M1 and M2 growth sucked most of the volatility out of the VIX index post-2008. Volatility is like energy: it never dies, it merely transforms. Every time you see the VIX hit some new lows, just think about it. Volatility has been shipped to the monetary aggregates or the real economy. Together with the PKO, they are the new financial system stabilizers. We have stable markets (a lot more stable than would be warranted considering the actual situation) in a context of unstable monetary policy aggregates and rates, and even more unstable economic output. Great choice of shock absorbers (for banks and financial intermediaries, not for the rest of us). Look at that as a paradigmatic result for a presumed success in achieving the CB’s global mandate!

Of course M1 global stability, and more so when we have an outright contraction, is key to my global bearishness. Particularly if the USD monetary aggregates are stable. Last January, the US monetary base hit a fresh low post QE3. Furthermore, the tiny rate hike does not help either. Minuscule as it may seem, we have to consider that, with a debt overhang of 370% of GDP for the US, tightening effects are amplified considerably. Add in the tightening in external USD denominated bonds, and the impact on other currencies with a USD peg. Most likely, Fed tightening will induce a slowdown in M2 growth in the USD economies. Unless money velocity picks up the tab, nominal GDP growth will have to slow further. Anybody for a prospective increase in money velocity this year?

If the liquidity environment is stable (ie without substantial M1 or M2 growth), valuations matter again. Valuations distinctively depict equities as an accident waiting to happen. I can’t think of a historical instance in which we got a sustainable multiple expansion from this level. So that puts the onus of price improvement squarely on the shoulders of profit growth (of the right kind).

If we look at NFC P&L accounts, it is obvious that valuations are getting worse, not better. Unless we reignite GAAP based, top line induced, non-eps based profit growth, the weight of actual valuation parameters is more than enough to take prices down (in a context of stable monetary magnitudes). Look at sales, and then take a look at index levels. Awesome disconnect!

Credit spreads also point to an equity price depreciation as well. They did not buy the bounce. CB’s are not to be underestimated though and can help maintain the divergence between equity risk premiums and the move in credit spreads for some time.

The global PKO will not support the aforementioned disconnects permanently, but it can sure alter the landscape somewhat -for a couple of months, or maybe even a year or two. The issue is that hidden behind the PKO techniques and their HFT vehicles, CB’s have a huge bazooka nicknamed (hat tip Ben Bernanke) “printing press”. We are all aware of that. Yeah, I know life is unfair. This is not a level battlefield, but CB’s defeat is nonetheless a clear outcome. I just want to be financially solvent by then, in order to enjoy the party when it does happen. And it will.

I have stopped myself out of 60% of my equity shorts for a small profit. I will stick with the rest of my shorts for a time. I begin to see red ink in my NAV statements for that trade, above 1900, so we are fooling around some decisive levels for it. I will stay the course for a reduced position. I have also diversified my shorts into some PIIG equity markets as well.

After trading the position for some substantial profits, I am also sticking to my Bund-OAT/BTP spread-widener trade. I do not see a spread decreasing environment even in a PKO induced regime of superimposed financial stability.

No currency plays this year for now. I see the major crosses in choppy sideways consolidation mode and expect no tectonic shifts of the kind we saw in 2014 and 2015. Action should be a lot more interesting in equities and credit spreads. Still big long SEK though.

I have taken some stops and monitored my trades because I want to live to see the CB’s die hard (financially). I am well in the money for the year and can afford them. Nevertheless, my understanding of the malfunctioning of the system can’t change that fast. My inner trader is always faster than the economist. It has to be, in order to remain solvent.

Fake markets can drive you crazy. The folks at Morgan Stanley are sarcastically suggesting that you do the opposite of what you think! Look at this next chart on negative alpha generated by the brightest minds. It’s getting worse as I write. There are only two possible explanations: hedge fund managers are dumb and have lost their touch….. or…. the markets are rigged! My take: my colleagues are far from dumb and even if they are they should outwit most of the remaining players.

Successive underperformance by alpha pickers does not point in the direction of inefficient alpha detection but points a finger directly at the Fed (and its POMO desk serfs). Alpha outperformance depends on your bottom-up analysis capabilities but is also contingent on markets that generate acceptable noise and low slippage. The PKO related strategies are based on noisy events, aimed at stop busting. Noise widens the bid-ask spread and increases slippage. Overcrowded trades and stop busting by POMOS do the rest. When the best underperform, it does not show their weakness but proves the market is too noisy (not to be confused with randomness) for fine-tuned investment strategies. It is not a good idea to expel talent from the market, and retain the dumbest players. We want efficient pricing, don’t we?

So it is really tough to make money in this environments unless you stick to CB’s recommended trades and embrace their assurances that all will be well. I remain undeterred once again. All in all, even after the umpteenth PKO event, my narrative remains unchanged.If this was an FOMC statement I would cut it that short! But this is a blog, and I will further explain.

The Fed is trying to normalize monetary policy. They will use stable markets to tighten more. That speaks badly for ERP’s or credit spreads. Post PKO effects, equities will turn south again. Credit spreads will continue to widen. Only high investment rating corporate bonds, or sovereigns, will continue to be well bid (until a global default takes place).

The sovereign bond rally is set to continue -but it is dangerous stuff. There is no room for error built in actual yields. Risk reward in long duration plays is awful. Pre global default, bonds are a long but post a global default, rates can back up considerably. Duration induced losses could be huge -and add on top of substantial haircuts on debt principals. Inflation could make a sharp comeback after a global balance sheet clean up.

Cash is not likely to last for long (holding it will be criminalized soon). While it does, and they don’t charge you for holding it in your accounts, it is one of the assets of choice. Be aware of bank risk though. Only US banks are moderately safe. The rest sport unsound balance sheets, and inordinate amounts of leverage when you take equity as a percentage of assets. Deutsche Bank goes as low as circa 3%. A look at CoCos recently issued shows just how desperate they are to improve their soundness. The sector’s prognosis is as bad as it can get.

Expect sluggish economic growth worldwide, and deflationary trends, for as long as the debt overhang persists. Debt matters (sorry to put you to shame Ben). It constrains economic activity and hurts productivity. Furthermore, it facilitates crazy policies by CB’s that make matters worse.

Commodities of all kinds are unlikely to be well bid under this debt overcast sky. That goes for oil as well. With energy, the issue is the timing of future events. Our civilization needs energy. Fossil energy is still needed. The question is whether demand will recover, or supply falters before the roll over to new energy takes place in strength. What comes next, massive electric transportation, or an ending of the demand-supply imbalance in fossil energy? Timing is key in an economic system that is inevitably addicted to cheap energy.

Fiat currencies with no anchor to gold or anything else (economic magnitudes of any kind) are the only choice available. And those with strong fundamentals try to nirp you out. In a sense, all fiat currencies are dangerous because their respective CB might try to debase them to follow the weakest currencies in their purchasing power decline. Money debasement is a sure ingredient of the final solution to the debt overhang. We just do not know to what extent -and in which currencies (probably most, if not all). Anyway, I think default driven debt restructuring will bear the brunt of the losses.

This benign environment (considering the debt overhang) is dependent on the market perception that debt is payable. The minute individual or corporate balance sheets start to clean it up, the process will be pervasive and self-feeding. Geopolitical moves have to be seen as dangerous when they threaten the dogma that debt will be paid. Brexit, refugees, Middle East instability etc, matter most if they threaten debt payments or induce fears of haircuts. If not, the stark truth is nobody really cares. The world is as selfish as it has always been.

Even if CB’s manage to keep the global financial system stable for a couple of years, the next bubble to come up on our radar screens is the entitlement promises bubble. Insurance companies and pension schemes will all be visibly bankrupt (bankrupt they already are: CALPERS still calculates future pensions based on the assumption of a prospective annual 7% return on their investments) in a couple of NIRP years. Even If we manage to fool everybody on our actual debt sustainability, entitlements will ensure a melt-down. Baby boomers will not be happy with their pensions. Entitlement promises are, for the most part, void of economic content,

Thank you very much for your kindness and interest in my extra-long posts. I do my best to incorporate some new interesting concepts, off the bank-research beaten track. But it is not that easy. I inevitably fall short in some posts.

So thanks again, and may I wish you all readers the best luck with your own trades. Provided you are not taking the other side of mine! Please forgive me for that. I have to be a touch selfish from time to time (I won’t make a habit of it). I will be back -if I’m still alive and solvent- right after my Easter holidays!